Implications of Change in Beneficial Shareholding

Whether you are buying a business, selling a business or merging two or more businesses, there are multifarious tax issues that need to be navigated. It is crucial to know what you are getting in to when you decide to grow your business through Mergers and Acquisitions (‘M&A’).

In any M&A transaction, tax considerations are one of the important factors that predominate and inevitably direct the manner in which the entire transaction has to be outlined. Failure to take into account tax implications might have far reaching consequences on the business and the shareholders. Preserving company’s past tax losses on change of ownership is one of the key factors which impact M&A transactions.

Denial of set-off of losses due to change in the shareholding of certain companies

As per the provisions of Income-tax Act, a taxpayer is eligible to carry forward loss for a period of eight assessment years immediately following the assessment year in which the loss was first computed. However, certain provisions of the Act deny set-off of losses due to change in the shareholding of certain companies.

Section 79 of the Income-tax act was introduced as an anti- abuse provision. The provisions of this section restrict a closely held company to carry forward and set off its business losses if 51% or more of its voting power in the year in which set-off is claimed is not beneficially held by the same shareholders who beneficially held 51% or more voting power on the last day of the previous year in which the loss was incurred.

As the term ‘beneficial ownership’ is not defined under the Act, the subject matter of litigation is whether the provisions are to be read in the context of the direct or immediate holding company, i.e. the registered or legal shareholder, or are they to be read in reference to the ultimate beneficial shareholder who has the voting power, directly or indirectly, in the company.

The interpretation of the term beneficial ownership has led to very different results and in the absence of clarity, there is a lot of uncertainty. Let’s have a look at the two schools of thought about application of the term ‘beneficial ownership’ while determining whether there was a change in the beneficial voting power.

In the facts of this case, two individual shareholders held beneficial voting power in the assessee company through intermediate holding companies. This shareholding remained unchanged from the inception. However, pursuant to a business re-organisation exercise, the individual shareholders became direct shareholders of the assessee by acquiring 100% shares from the intermediate holding companies in AY 2012-13. In the year of change in shareholding, the assessee company had claimed brought forward losses in the computation of income.

The Assessing Officer (‘AO’) denied the claim of set off of such losses on the basis of the fact that there was a change in more than 49% of the shareholding in the assessee company in year in which the loss was incurred, vis-à-vis the shareholding in the year in which the loss was claimed for setting off. The AO placed reliance on the Supreme Court decision in the case of Vodafone International Holdings B.V. vs. Union of India (SC) to support that registered shareholders were also beneficial shareholders, and any change in the shareholding may trigger the provisions of Section 79 to deny set off of losses. In Vodafone International (supra) it was held that it is important for both the government and the Courts to look holistically at the legal nature of the transaction in its entirety. The “look- through” approach is permissible only in instances where the transaction is a sham or is for the purposes of tax avoidance.

The Tribunal in the present case decided that in order to attract the provisions of Section 79 of the Act the relevant aspect would be beneficial shareholding and not the registered shareholding.

The intent behind introducing such anti-abuse provisions, as explained by the Supreme Court in the case of Commissioner of Income Tax vs. Italindia Cotton Co. P. Ltd., is to discourage persons claiming a reduction of their tax liability on the profits earned in companies which have sustained losses in earlier years.

It was not unusual for a group of persons to acquire a company which had suffered losses in the earlier years in the expectation that the company would earn substantial profits after such acquisition, eventually resulting in benefit by way of reduction of the tax liability of those profits on a set off of losses carries forward from earlier years before the acquisitions.

The word used in Section 79 of the Act is ‘held’ and not ‘owned’. This indicates that ownership of the shares with the same person is not contemplated for denying the set off of the loss. The phrase ‘beneficially held’ would contemplate wider meaning to cover a situation wherein if a person is able to influence voting rights to the extent of 51 per cent in the company seeking set off through a chain of holding then same would be sufficient not to disentitle the set off of the loss.

The purpose of Section 79 of the Act would be that benefit of carry forward and set-off of business losses for previous years of a company should not be misused by any new owner, who may purchase the shares of the Company, only to get the benefit of set-off of business losses of previous years, which may bear profits in the subsequent years after the new owner takes over the Company.

A plain reading of this provision that shareholding is not the condition but exercise of ‘voting power’ is important for the purpose of invoking Section 79. Thus, Section 79 will not be triggered if the beneficial holders remain the same, even if there is change in the immediate shareholders.

The direct registered ownership approach

In contrast to the above discussed judgments, the Delhi High Court in the case of Yum Restaurants (India) Private Limited held that in the absence of any specific agreement, the ultimate holding company cannot be considered as the beneficial owner, since beneficial ownership stays with the immediate holding company and that there would not be any need to pierce the corporate veil. The company contended that there was no change in the beneficial ownership of shares because both the predecessor and the successor companies were subsidiaries of the same holding company and thus, the beneficial interest remained the same, i.e. of the ultimate holding company.

However, it was held that where it was held that a corporate entity is a separate legal entity and hence, change in registered ownership will have an impact on the carry forward of business losses of the taxpayer under section 79.

There is hardly any need to emphasise that holding and subsidiary companies are, albeit bound by their relationship, but do not lose their individual existence in the commercial world.

Both are separately liable for the respective transaction undertaken by them. The corporate veil cannot be pierced to treat both as one and the same so as to escape the natural consequences of section 79.

The above decisions were distinguished and not applied in the case of Wadhwa & Associates (supra) on the basis that the taxpayers had failed to show that there was no change in beneficial ownership.

The way forward

This is a classic issue where one can how an issue has been handled differently (Wadhwa Associates vis-à-vis Tainwala Trading and Investments) at a same forum (ITAT Mumbai) in different assessment years.

The divergent decisions by different courts have created an ambiguity assuming particular significance in the context of intra-group restructuring undertaken through M&A transactions where there is no actual transfer of tax losses to be utilised by a third party.

The prolonged litigation and different interpretations across different ITATs and Courts, thus, require clarifications to ensure that they meet the intent with which the provision was introduced and also do not cause any undue hardship to the assessees.